CRUDE OIL: WKLY MARKET RECAP
West Texas Intermediate (WTI) has surged over 5% since the close on Monday, and is up 5.5% on the week, closing the week out at $65.81 per bbl, the highest levels seen since crude touched over $66.00 per barrel on January 28th 2018. The million dollar question for direct participation investors is; are these prices here to stay, and is now the right time to deploy capital into drilling projects?
YES. AND HERE’S WHY…
There are two essential reasons why the price improvement of oil is taking place.
TRADITIONAL CRUDE OIL MARKET DRIVERS
The first reason goes to the typical and obvious drivers of the crude oil markets…
- United States production levels
- Currency exchange rates
American extraction came in much lower than expected for the week. Estimates from the Energy Information Administration (EIA) showed a decline of 2.6 million barrels of US crude stock. However analysts had expected a 2.5 million increase, a different of 5.1 million barrels of oil.
Geopolitics can often be used to explain all manner of events in the energy sector, especially market moves that make less “fundamental” sense.
Let’s take a quick peek at geopolitical news headlines over the last week:
- Rising instability in the Persian Gulf as the Saudi Crown Prince visits Washington D.C. as President Trump considers ending the Iranian Nuclear Accord
- Washington considering sanctions against a failing Venezuelan socialist state
- Intensifying Libyan conflict (1 MM barrel per day producer/exporter)
- Chinese saber rattling in the South China Sea
- ongoing Nigerian domestic problems (1.7MM barrel per day producer/exporter)
Uncertainty resulting from cross-border and global unrest is an ongoing staple element to the oil markets. The main influence Geopolitics has on the futures market is how one regards the potential future oil availability, but until the oil flow is actually impacted, its pressure is more apparent than real.
UNDERSTANDING DEMAND AND HOW TO MEASURE IT
Global demand for crude oil remains one of the most misunderstood yardsticks to measure the future price of oil. Economics 101- yes the balance between supply and demand certainly does influence price, but the REAL importance is the effect projected demand has on the amount of EXCESS supply. Too much excess volume will prompt prices lower, while the opposite will drive prices higher. When we speak of “market balance,” it always assumes the availability of excess volume beyond immediate requirements.
That balance that the oil markets and investors alike have sought since the price of oil came tumbling down in 4Q 2014 is rapidly emerging and, in some regions may have already arrived. It appears that the accordion effect of slashed CAPEX drilling/exploration budgets of major IOC’s and large private equity backed Independents, as many analysts predicted it would, is finally showing itself as the supply/demand discrepancies narrow.
THE IMPACT OF CURRENCY EXCHANGE RATES ON THE OIL MARKETS
Currency exchange rates speak about the foreign exchange rate for the dollar. Thanks to a little secret Nixon era agreement made between the United States and Saudi Arabia as a countermeasure to sustain “artificial” global demand for the US Dollar in wake of the crumbling Bretton Woods international monetary system, the vast majority of all international oil trade is denominated in US Dollars. (We can talk more about the Petro-Dollar and the influence on American history and foreign policy at a later time) When the value of the declines against other currencies, especially the EURO, the dollar value of a barrel of oil increases. This relationship makes owning interests at the wellhead one of the king of cash flowing hedges against US inflation. Recently, the weakening dollar has resulted in that upward pressure on crude.
UNDERSTANDING FUTURES MARKET TRENDS
The common theme throughout all of this is how the forward price of oil is perceived by the trader. Traders will peg the price in a future contract to the expected cost of the next available barrel of crude. Options and other derivatives are then applied as insurance against movements in either direction. In effect, the perceived direction of prices becomes the driving engine in traders’ actions. Keeping this in mind, therefore, the most direct way of concluding which way the market will move is pretty straightforward. It involves the number of short versus long contracts being exercised. Until last week, short contracts held considerable sway. That changed abruptly on Thursday with long contracts taking over, making LONGS the new market driver. Another consequence of this transition is the need for holders of short contracts to liquidate positions, requiring they go back into the market and purchase contracts. This serves as another upward pressure on prices. At some point all of this evens out and sets a new market equilibrium. After all, balance is what trading markets always seek.
You put all of this together and it bodes quite well for investment returns in this sector. It’s time for direct participation investors to shake off fears developed from the 2014 US Shale Oil over-saturation, and put capital back into American oil drilling action for strong returns.
Veteran Oil Partners LLC